In a sign of how dramatic the reversals of fortune have been on Wall Street, hedge funds, until recently considered the riskiest players in the financial services industry, are now questioning how safe it is to leave cash and securities with their prime brokers, the securities firms that provide credit, brokerage, clearing, and sometimes fund administration. The issue arises because some prime brokerage agreements provide that assets in the hands of the prime brokers are ceded to them.
From the Financial Times:
Call it the final indignity for banks: their hedge fund customers, generally regarded as the most hazardous financial operators, are questioning the creditworthiness of their prime brokers.
Some of the world’s biggest hedge funds have reviewed agreements with their bankers, assessing whether assets and cash left with the prime brokers are safe.
Hedge funds, bankers and advisers say this has seen a shift in assets away from those banks regarded as riskiest following multi-billion dollar write-offs – bad news for the banks given the high profitability of prime broking.
“It is quite paradoxical,” said Angelos Metaxa, a director of CM Advisors, a $3bn [€2.05bn] Geneva-based fund of hedge funds. “In August, everyone was worried about a hedge fund blowing up, but now they are worried about a bank blowing up and taking a few hedge funds with it.”
Hedge funds rely on prime brokers to provide financing and to act as custodian for their investments. But their exposure if there was a collapse depends on how their agreements are structured. So-called “rehypothecation” – when legal ownership of the assets rests with the bank, rather than the hedge fund – is now being re-examined by the funds.
The move is being accelerated by pressure from investors, many of whom have begun to question the managers of the funds they invest in about the risks they may be running.
One of London’s largest managers said it had been grilled at length by the directors of its hedge funds about bank risk, and had moved some assets between prime brokers as a result.
Robert Sloan, a managing partner of S3 Partners, a New York financing specialist, said: “I don’t think the hedge funds are the ones taking the risk [of a bank failure] seriously – but their investors are making them take it seriously.”
Some prime brokers, including Barclays Capital and Credit Suisse, are using their position as part of big commercial banks as a marketing tool, while other brokers that were not hit by the subprime crisis say they have been beneficiaries of the worries.
However, some prime brokers have fought back with detailed explanations for funds of their financial strength and guarantees which protect their money in the event of failure.
In many cases, hedge funds are being given clear choices: keep their assets segregated, so they are completely safe, or switch them to the prime broker’s name and get a discount.